Hong Kong saw its borrowing costs in the money market surge to a near eight-year high, with the US Federal Reserve almost certain to raise interest rates later this week.

Business, December 15

There is an old financial saying that I think holds some great wisdom despite being a little outdated – political stability is money at 6 per cent.

Think about it and you will see that interest rates must indeed be the best benchmark you can find of political stability.

The more stable the country the more confident people will be of their investments, and the lower the interest rates until you hit bottom at relative full stability.

But clearly it is a dated statement. Back when it was coined, that bottom was considered to be 6 per cent. Today in the United States the federal funds rate has been at near zero for eight years and the benchmark 10-year Treasury yield has been less than 6 per cent for 16 years.

I will still argue, however, that the saying is correct. At less than 6 per cent you progressively get a distorted financial system that misallocates capital because it can no longer be properly priced.

The money goes to speculation in financial markets and the productive economy is shunted aside.

This is in fact what has happened in the US and it progressively creates a system where interest rates can no longer return to normal levels except at the risk of economic collapse.

Take, for instance, the borrowings of the US federal government, now at US$20 trillion, carried at present at an average interest charge of about 2.2 per cent. Put that debt at a 6 per cent interest rate and you would get an annual interest cost of US$1.2 trillion. The actual is at present about US$450 billion.

Do you think American taxpayers, politicians, consumers, American anyone would blithely put up with an extra US$750 billion a year in government debt costs for the same amount of debt? They will storm the Fed for relief.

They would in particular do so because as individuals they are already stretched with an average household debt of 180 per cent of household income, thanks also to the delights of a long period of ultra-low interest rates.

And could they tolerate 6 per cent money when it would make virtually every job insecure and destroy the value of their investments? The US stock market is at present priced at a sky-high 26 times historic earnings on the S&P 500 index and earnings are now actually declining at an annual rate of 8 per cent.

We are potentially talking about a new world record in the high dive, folks, if this market gets spooked.

So when the Fed raises its federal funds rate by a timid 25 basis points from 0.41 per cent to 0.66 per cent, the real question is not whether we are returning to normalised interest rates but whether it will mark the top of this interest rate cycle.

The US economy simply cannot take much more in its present distorted state.

And now relate this to Hong Kong. We are locked to the US interest rate trends by our peg to the US dollar and the best indicator we have here of where it is taking us is our own version of the long bond, the domestic property price index for flats of 430 square feet or less.

Look at the chart. Despite all the punitive stamp duties and trouble talk that our immediate past financial secretary could throw at it, this market is telling you that it found the Fed’s last 25 basis point hike to be a false alarm.

Unlike Chicken Little, the market doesn’t think the sky will fall in any time soon.